Crescive norms

8.1 What Is Corporate Strategy?

LO 8-1

Define corporate strategy and describe the three dimensions along which it is assessed.

Strategy formulation centers around the key questions of where and how to compete. Business strategy concerns the question of how to compete in a single product market. As discussed in Chapter 6 , the two generic business strategies that firms can follow to pursue their quest for competitive advantage are to increase differentiation (while containing cost) or lower costs (while maintaining differentiation). If trade-offs can be reconciled, some firms might be able to pursue a blue ocean strategy by increasing differentiation and lowering costs. As firms grow, they are frequently expanding their business activities through seeking new markets both by offering new products and services and by competing in different geographies. Strategic leaders must formulate a corporate strategy to guide continued growth. To gain and sustain competitive advantage, therefore, any corporate strategy must align with and strengthen a firm’s business strategy, whether it is a differentiation, cost-leadership, or blue ocean strategy.

Corporate strategy comprises the decisions that leaders make and the goal-directed actions they take in the quest for competitive advantage in several industries and markets simultaneously. 3 It provides answers to the key question of where to compete. Corporate strategy determines the boundaries of the firm along three dimensions: vertical integration along the industry value chain, diversification of products and services, and geographic scope (regional, national, or global markets). Strategic leaders must determine corporate strategy along the three dimensions:

1. Vertical integration: In what stages of the industry value chain should the company participate? The industry value chain describes the transformation of raw materials into finished goods and services along distinct vertical stages.

2. Diversification: What range of products and services should the company offer?

3. Geographic scope: Where should the company compete geographically in terms of regional, national, or international markets?

In most cases, underlying these three questions is an implicit desire for growth. The need for growth is sometimes taken so much for granted that not every manager understands all the reasons behind it. A clear understanding will help strategic leaders to pursue growth for the right reasons and make better decisions for the firm and its stakeholders.

WHY FIRMS NEED TO GROW

LO 8-2

Explain why firms need to grow, and evaluate different growth motives.

Several reasons explain why firms need to grow. These can be summarized as follows:

1. Increase profits.

2. Lower costs.

3. Increase market power.

4. Reduce risk.

5. Motivate management.

Let’s look at each reason in turn.

INCREASE PROFITS

Profitable growth allows businesses to provide a higher return for their shareholders, or owners, if privately held. For publicly traded companies, the stock market valuation of a firm is determined to some extent by expected future revenue and profit streams. As featured in the ChapterCase, Amazon’s high stock market valuation is based to a large extent on expectations of future profitability, because the company invests for the long term and as such has yet to show consistent profitability.

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If firms fail to achieve their growth target, their stock price often falls. With a decline in a firm’s stock price comes a lower overall market capitalization, exposing the firm to the risk of a hostile takeover. Moreover, with a lower stock price, it is more costly for firms to raise the required capital to fuel future growth by issuing stock.

LOWER COSTS

Firms are also motivated to grow in order to lower their cost. As discussed in detail in Chapter 6 , a larger firm may benefit from economies of scale, thus driving down average costs as their output increases. Firms need to grow to achieve minimum efficient scale, and thus stake out the lowest-cost position achievable through economies of scale.

INCREASE MARKET POWER

Firms might be motivated to achieve growth to increase their market share and with it their market power. When discussing an industry’s structure in Chapter 3 , we noted that firms often consolidate industries through horizontal mergers and acquisitions (buying competitors) to change the industry structure in their favor (we’ll discuss mergers and acquisitions in detail in Chapter 9 ). Fewer competitors generally equates to higher industry profitability. Moreover, larger firms have more bargaining power with suppliers and buyers (see the discussion of the five forces in Chapter 3 ).

REDUCE RISK

Firms might be motivated to grow in order to diversify their product and service portfolio through competing in a number of different industries. The rationale behind these diversification moves is that falling sales and lower performance in one sector (e.g., GE’s oil and gas unit) might be compensated by higher performance in another (e.g., GE’s health care unit). Such conglomerates attempt to achieve economies of scope (as first discussed in Chapter 6 ).

MOTIVATE MANAGEMENT

Firms need to grow to motivate management. Growing firms afford career opportunities and professional development for employees. Firms that achieve profitable growth can also pay higher salaries and spend more on benefits such as health care insurance for its employees and paid parental leave, among other perks.

Research in behavioral economics, moreover, suggests that firms may grow to achieve goals that benefit managers more than stockholders. 4 As we will discuss in detail when presenting the principal–agent problem later in the chapter, managers may be more interested in pursuing their own interests such as empire building and job security—plus managerial perks such as corporate jets or executive retreats at expensive resorts—rather than increasing shareholder value. Although there is a weak link between CEO compensation and firm performance, the CEO pay package often correlates more strongly with firm size. 5

Finally, we should acknowledge that promising businesses can fail because they grow unwisely—usually too fast too soon, and based on shaky assumptions about the future. There is a small movement counter to the need for growth, seen both in small businesses and social activism. Sometimes small-business owners operate a business for convenience, stability, and lifestyle; growth could threaten those goals. In social entrepreneurship, business micro-solutions are often operated outside of capital motives, where the need to solve a social problem outweighs the need of the firm to insure longevity beyond the solution of the problem.

THREE DIMENSIONS OF CORPORATE STRATEGY

All companies must navigate the three dimensions of vertical integration, diversification, and geographic scope. Although many managers provide input, the responsibility for corporate strategy ultimately rests with the CEO. Jeff Bezos, Amazon’s CEO, determined in what stages of the industry value chain Amazon would participate (question 1). With its prevalent delivery lockers in large metropolitan areas and its first brick-and-mortar retail store opened Page 270in New York City, Amazon moved forward in the industry value chain to be closer to its end customer. With its offering of Amazon-branded electronics and other everyday items, it also moved backward in the industry value chain toward manufacturing, production. Similarly, the creation of AWS, now the largest cloud-computing service provider globally with some 100 million customers, is a backward vertical integration move. AWS provides Amazon with back-end IT services such as website hosting, computing power, data storage and management, etc., which in turn are all critical inputs to its online retail business.

Bezos also chooses what range of products and services to offer, and which not to offer (question 2). The ChapterCase discusses Amazon’s diversification over time. Finally, Bezos also decided to customize certain country-specific websites despite the instant global reach of ecommerce firms. With this strategic decision, he decided where to compete globally in terms of different geographies beyond the United States. In short, Bezos determined where Amazon competes geographically (question 3).

Where to compete in terms of industry value chain, products and services, and geography are the fundamental corporate strategic decisions. The underlying strategic management concepts that will guide our discussion of vertical integration, diversification, and geographic competition are core competencies, economies of scale, economies of scope, and transaction costs.

· ▪ Core competencies are unique strengths embedded deep within a firm (as discussed in Chapter 4 ). Core competencies allow a firm to differentiate its products and services from those of its rivals, creating higher value for the customer or offering products and services of comparable value at lower cost. According to the resource-based view of the firm, a firm’s boundaries are delineated by its knowledge bases and core competencies. 6 Activities that draw on what the firm knows how to do well (e.g., Amazon’s core competency in developing proprietary recommendation algorithms) should be done in-house, while noncore activities such as payroll and facility maintenance can be outsourced. In this perspective, the internally held knowledge underlying a core competency determines a firm’s boundaries.

· ▪ Economies of scale occur when a firm’s average cost per unit decreases as its output increases (as discussed in Chapter 6 ). Anheuser-Busch InBev (AB InBev), the largest global brewer (producer of some 225 brands worldwide, including famous ones such as Budweiser, Bud Light, Miller, Stella Artois, and Beck’s), reaps significant economies of scale. After AB InBev merged with SABMiller in a more than $100 billion deal in 2016, it now captures some 30 percent of global beer consumption. 7 As a consequence of its huge scale, the beer giant captures some 50 percent of global beer profits. In terms of beer volume, the new AB InBev is also more than double the size of Heineken, the number-two competitor worldwide. Given its tremendous size, AB InBev is able to spread its fixed costs over the millions of gallons of beer it brews each year, in addition to the significant buyer power its large market share affords. Larger market share, therefore, often leads to lower costs.

· ▪ Economies of scope are the savings that come from producing two (or more) outputs or providing different services at less cost than producing each individually, though using the same resources and technology (as discussed in Chapter 6 ). Leveraging its online retailing expertise, for example, Amazon benefits from economies of scope: It can offer a large range of different product and service categories at a lower cost than it would take to offer each product line individually.

· ▪ Transaction costs are all costs associated with an economic exchange. Applying the logic of transaction cost economics enables managers to answer the question of whether it is cost-effective for their firm to expand its boundaries through vertical integration or diversification. This implies taking on greater ownership of the production of needed inputs or of the channels by which it distributes its outputs, or adding business units that offer new products and services.

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We continue our study of corporate strategy by drawing on transaction cost economics to explain vertical integration, meaning the choices a firm makes concerning its boundaries. Later, we will explore managerial decisions relating to diversification, which directly affect the firm’s range of products and services in multi-industry competition. The third question of geographic scope will receive attention later, especially in Chapter 10 .

8.2 The Boundaries of the Firm

LO 8-3

Describe and evaluate different options firms have to organize economic activity.

Determining the boundaries of the firm so that it is more likely to gain and sustain a competitive advantage is the critical challenge in corporate strategy. 8 T ransaction cost economics provides useful theoretical guidance to explain and predict the boundaries of the firm. Insights gained from transaction cost economics help strategic leaders decide what activities to do in-house versus what services and products to obtain from the external market. This stream of research was initiated by Nobel Laureate Ronald Coase, who asked a fundamental question: Given the efficiencies of free markets, why do firms even exist? The key insight of transaction cost economics is that different institutional arrangements—markets versus firms—have different costs attached.

Transaction costs are all internal and external costs associated with an economic exchange, whether it takes place within the boundaries of a firm or in markets. 9 Exhibit 8.2 visualizes the notion of transaction costs. It shows the respective internal transactions costs within Firm A and Firm B, as well as the external transactions that occur when Firm A and Firm B do business with one another.

EXHIBIT 8.2 Internal and External Transaction Costs

An illustration of internal transaction costs within Firm A and Firm B. External transaction costs also occur when the firms interact in the market.

The total costs of transacting consist of external and internal transaction costs, as follows:

· ▪ When companies transact in the open market, they incur external transaction costs : the costs of searching for a firm or an individual with whom to contract, and then negotiating, monitoring, and enforcing the contract.

· ▪ Transaction costs can occur within the firm as well. Considered internal transaction costs these include costs pertaining to organizing an economic exchange within a firm—for example, the costs of recruiting and retaining employees; paying salaries and benefits; setting up a shop floor; providing office space and computers; and organizing, Page 272monitoring, and supervising work. Internal transaction costs also include administrative costs associated with coordinating economic activity between different business units of the same corporation such as transfer pricing for input factors, and between business units and corporate headquarters including important decisions pertaining to resource allocation, among others. Internal transaction costs tend to increase with organizational size and complexity.

FIRMS VS. MARKETS: MAKE OR BUY?

Predictions derived from transaction cost economics guide strategic leaders in deciding which activities a firm should pursue in-house (“make”) versus which goods and services to obtain externally (“buy”). These decisions help determine the boundaries of the firm. In some cases, costs of using the market such as search costs, negotiating and drafting contracts, monitoring work, and enforcing contracts when necessary may be higher than integrating the activity within a single firm and coordinating it through an organizational hierarchy. When the costs of pursuing an activity in-house are less than the costs of transacting for that activity in the market (Cin–house < Cmarket), then the firm should vertically integrate by owning production of the needed inputs or the channels for the distribution of outputs. In other words, when firms are more efficient in organizing economic activity than are markets, which rely on contracts among many independent actors, firms should vertically integrate. 10

For example, rather than contracting in the open market for individual pieces of software code, Google (a unit of Alphabet) hires programmers to write code in-house. Owning these software development capabilities is valuable to the firm because its costs, such as salaries and employee benefits to in-house computer programmers, are less than what they would be in the open market. More importantly, Google gains economies of scope in software development resources and capabilities and reduces the monitoring costs. Skills acquired in writing software code for its different internet-based service offerings are transferable to new offerings. Programmers working on the original proprietary software code for the Google search engine leveraged these skills in creating a highly profitable online advertising business (AdWords and AdSense). 11 Although some of Google’s software products are open source, such as the Android operating system, many of the company’s internet services are based on closely guarded and proprietary software code. Google, like many leading high-tech companies such as Amazon, Apple, Facebook, and Microsoft, relies on proprietary software code and algorithms, because using the open market to transact for individual pieces of software would be prohibitively expensive. Also, the firms would need to disclose the underlying software code to outside developers, thus negating the value-creation potential.

Firms and markets, as different institutional arrangements for organizing economic activity, have their own distinct advantages and disadvantages, summarized in Exhibit 8.3.

EXHIBIT 8.3 Organizing Economic Activity: Firms vs. Markets

A summary of the advantages and disadvantages of a firm versus a market approach.

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The advantages of firms include:

· ▪ The ability to make command-and-control decisions by fiat along clear hierarchical lines of authority.

· ▪ Coordination of highly complex tasks to allow for specialized division of labor.

· ▪ Transaction-specific investments, such as specialized robotics equipment that is highly valuable within the firm, but of little or no use in the external market.

· ▪ Creation of a community of knowledge, meaning employees within firms have ongoing relationships, exchanging ideas and working closely together to solve problems. This facilitates the development of a deep knowledge repertoire and ecosystem within firms. For example, scientists within a biotech company who worked together developing a new cancer drug over an extended time period may have developed group-specific knowledge and routines. These might lay the foundation for innovation, but would be difficult, if not impossible, to purchase on the open market. 12

The disadvantages of organizing economic activity within firms include:

· ▪ Administrative costs because of necessary bureaucracy.

· ▪ Low-powered incentives, such as hourly wages and salaries. These often are less attractive motivators than the entrepreneurial opportunities and rewards that can be obtained in the open market.

· ▪ The principal–agent problem.

The principal–agent problem is a major disadvantage of organizing economic activity within firms, as opposed to within markets. It can arise when an agent such as a manager, performing activities on behalf of the principal (the owner of the firm), pursues his or her own interests. 13 Indeed, the separation of ownership and control is one of the hallmarks of a publicly traded company, and so some degree of the principal–agent problem is almost inevitable. 14 For example, a manager may pursue his or her own interests such as job security and managerial perks (e.g., corporate jets and golf outings) that conflict with the principal’s goals—in particular, creating shareholder value. One potential way to overcome the principal–agent problem is to give stock options to managers, thus making them owners. We will revisit the principal–agent problem, with related ideas, in Chapters 11 and 12.

The advantages of markets include:

· ▪ High-powered incentives. Rather than work as a salaried engineer for an existing firm, for example, an individual can start a new venture offering specialized software. High-powered incentives of the open market include the entrepreneur’s ability to capture the venture’s profit, to take a new venture through an initial public offering (IPO), or to be acquired by an existing firm. In these so-called liquidity events, a successful entrepreneur can make potentially enough money to provide financial security for life. 15

· ▪ Increased flexibility. Transacting in markets enables those who wish to purchase goods to compare prices and services among many different providers.

The disadvantages of markets include:

· ▪ Search costs. On a very fundamental level, perhaps the biggest disadvantage of transacting in markets, rather than owning the various production and distribution activities within the firm itself, entails nontrivial search costs. In particular, a firm faces search costs when it must scour the market to find reliable suppliers from among the many firms competing to offer similar products and services. Even more difficult can be the search to find suppliers when the specific products and services needed are not offered by firms currently in the market. In this case, production of supplies would require transaction-specific investments, an advantage of firms.

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▪ Opportunism by other parties. Opportunism is behavior characterized by self-interest seeking with guile (we’ll discuss this in more detail later).

· ▪ Incomplete contracting. Although market transactions are based on implicit and explicit contracts, all contracts are incomplete to some extent, because not all future contingencies can be anticipated at the time of contracting. It is also difficult to specify expectations (e.g., What stipulates “acceptable quality” in a graphic design project?) or to measure performance and outcomes (e.g., What does “excess wear and tear” mean when returning a leased car?). Another serious hazard inherent in contracting is information asymmetry (which we discuss next).

· ▪ Enforcement of contracts. It often is difficult, costly, and time-consuming to enforce legal contracts. Not only does litigation absorb a significant amount of managerial resources and attention, but also it can easily amount to several million dollars in legal fees. Legal exposure is one of the major hazards in using markets rather than integrating an activity within a firm’s hierarchy.

Frequently, sellers have better information about products and services than buyers, which creates information asymmetry , a situation in which one party is more informed than another, because of the possession of private information. When firms transact in the market, such unequal information can lead to a lemons problem. Nobel Laureate George Akerlof first described this situation using the market for used cars as an example. 16 Assume only two types of used cars are sold: good cars and bad cars (lemons). Good cars are worth $8,000 and bad ones are worth $4,000. Moreover, only the seller knows whether a car is good or is a lemon. Assuming the market supply is split equally between good and bad cars, the probability of buying a lemon is 50 percent. Buyers are aware of the general possibility of buying a lemon and thus would like to hedge against it. Therefore, they split the difference and offer $6,000 for a used car. This discounting strategy has the perverse effect of crowding out all the good cars because the sellers perceive their value to be above $6,000. Assuming that to be the case, all used cars offered for sale will be lemons.

images©Big Pants Production/Shutterstock.com RF

The important take-away here is caveat emptor—buyer beware. Information asymmetries can result in the crowding out of desirable goods and services by inferior ones. This has been shown to be true in many markets, not just for used cars, but also in ecommerce (e.g., eBay), mortgage-backed securities, and even collaborative R&D projects. 17

ALTERNATIVES ON THE MAKE-OR-BUY CONTINUUM

The “make” and “buy” choices anchor each end of a continuum from markets to firms, as depicted in Exhibit 8.4 . Several alternative hybrid arrangements are available between these two extremes. 18 Moving from transacting in the market (“buy”) to full integration (“make”), alternatives include short-term contracts as well as various forms of strategic alliances (long-term contracts, equity alliances, and joint ventures) and parent–subsidiary relationships.

EXHIBIT 8.4 Alternatives on the Make-or-Buy Continuum

A continuum diagram. Access the text alternative for Exhibit 8.4

SHORT-TERM CONTRACTS

When engaging in short-term contracting, a firm sends out requests for proposals (RFPs) to several companies, which initiates competitive bidding for contracts to be awarded with a short duration, generally less than one year. 19 The benefit to this approach lies in the fact that it allows a somewhat longer planning period than individual market transactions. Moreover, the buying firm can often demand lower prices due to the competitive bidding process. The drawback, however, is that firms responding to the RFP have no incentive to make any transaction-specific investments (e.g., buy new machinery to improve product quality) due to the short duration of the contract. This is exactly what happened in the U.S. automotive Page 275industry when GM used short-term contracts for standard car components to reduce costs. When faced with significant cost pressures, suppliers reduced component quality in order to protect their eroding margins. This resulted in lower-quality GM cars, contributing to a competitive advantage vis-à-vis competitors, most notably Toyota but also Ford, which used a more cooperative, longer-term partnering approach with suppliers. 20

STRATEGIC ALLIANCES

As we move toward greater integration on the make-or-buy continuum, the next organizational forms are strategic alliances. Strategic alliances are voluntary arrangements between firms that involve the sharing of knowledge, resources, and capabilities with the intent of developing processes, products, or services. 21 Alliances have become a ubiquitous phenomenon, especially in high-tech industries. Moreover, strategic alliances can facilitate investments in transaction-specific assets without encountering the internal transaction costs involved in owning firms in various stages of the industry value chain.

Strategic alliances is an umbrella term that denotes different hybrid organizational forms—among them, long-term contracts, equity alliances, and joint ventures. Given their prevalence in today’s competitive landscape as a key vehicle to execute a firm’s corporate strategy, we take a quick look at strategic alliances here and then study them in more depth in Chapter 9 .

Long-Term Contracts.

We noted that firms in short-term contracts have no incentive to make transaction-specific investments. Long-term contracts, which work much like short-term contracts but with a duration generally greater than one year, help overcome this drawback. Long-term contracts help facilitate transaction-specific investments. Licensing , for example, is a form of long-term contracting in the manufacturing sector that enables firms to commercialize intellectual property such as a patent. The first biotechnology drug to reach the market, Humulin (human insulin), was developed by Genentech and commercialized by Eli Lilly based on a licensing agreement.

In service industries, franchising is an example of long-term contracting. In these arrangements, a franchisor, such as McDonald’s, Burger King, 7-Eleven, H&R Block, or Subway, grants a franchisee (usually an entrepreneur owning no more than a few outlets) the right to use the franchisor’s trademark and business processes to offer goods and services that carry the franchisor’s brand name. Besides providing the capital to finance the expansion of the chain, the franchisee generally pays an up-front (buy-in) lump sum to the franchisor plus a percentage of revenues.

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Equity Alliances.

Yet another form of strategic alliance is an equity alliance—a partnership in which at least one partner takes partial ownership in the other partner. A partner purchases an ownership share by buying stock or assets (in private companies), and thus making an equity investment. The taking of equity tends to signal greater commitment to the partnership. Strategy Highlight 8.1 describes how soft drink giant Coca-Cola Co. formed an equity alliance with energy-drink maker Monster.

Strategy Highlight 8.1

Is Coke Becoming a Monster?

While Americans are drinking ever more nonalcoholic beverages, the demand for longtime staples such as the full-calorie Coke or Pepsi are in free fall. More health-conscious consumers are moving away from sugary drinks at the expense of Coke and Pepsi, the two archrivals among regular colas. Unlike in the 1990s, however, Americans are not replacing them with diet sodas, but rather with bottled water and energy drinks. Indeed, Coca-Cola was slow to catch the trend toward bottled water and other more healthy choices such as vitamin water. Protecting its wholesome image, the conservative Coca-Cola Co. shunned energy drinks. The makers of energy drinks, such as 5-hour Energy, Red Bull, Monster, Rockstar, and Amp Energy, have faced wrongful death lawsuits. PepsiCo, on the other hand, was much more aggressive in moving into the energy-drink business with Amp Energy (owned by PepsiCo) and Rockstar (distributed by PepsiCo).

A photo of a Monster-sponsored racing car. The Coca-Cola Co. holds an ownership stake through an equity alliance in the Monster Beverage Corp., which sponsors the NASCAR top racing series. ©Chris Graythen/Getty Images Sport/Getty Images

Albeit late to the party, Coca-Cola decided to not miss out completely on energy drinks, one of the fastest-growing segments in nonalcoholic beverages. After years of deliberation, in 2014 the Coca-Cola Co. formed an equity alliance with Monster Beverage Corp., spending $2 billion for a 16.7 percent stake in the edgy energy-drink company. This values the privately held Monster Beverage at roughly $12 billion. What might have finally persuaded Coca-Cola to make this decision? Not only was Monster now number one with 40 percent market share of the over $6 billion energy-drink industry, but the company also had settled a number of wrongful death lawsuits out of court. Meanwhile, however, the U.S. Food and Drug Administration is still investigating some 300 “adverse event” reports allegedly linked to the consumption of energy drinks, including 31 deaths. While the Coca-Cola Co. insists that it completed its due diligence before concluding that energy drinks are safe, it hedges its bets with a minority investment in Monster rather than an outright acquisition. This allows the market leader in nonalcoholic beverages to benefit from the explosive growth in energy drinks, while limiting potential exposure of Coca-Cola’s wholesome image and brand. Meanwhile, Monster paid about $20 million to sponsor NASCAR’s top racing series in 2017. 22

Why is the Coca-Cola Co. forming an equity alliance with Monster Beverage Corp. and not just entering a short- or long-term contract, such as a distribution and profit-sharing agreement? One reason is that an equity investment in Monster might give Coca-Cola an inside look into the company. Gaining more information could be helpful if Coca-Cola decides to acquire Monster in the future. Gaining such private information might not be possible with a mere contractual agreement. Buying time is also helpful so Coca-Cola Co. can see how the wrongful death lawsuits play out, and thus limit the potential downside to Coke’s wholesome brand image (as mentioned in Strategy Highlight 8.1 ).

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Moreover, in strategic alliances based on a mere contractual agreement, one transaction partner could attempt to hold up the other by demanding lower prices or threatening to walk away from the agreement (with whatever financial penalties might be included in the contract). This might be a real concern for Monster because Coca-Cola, with about $50 billion in annual sales, is about 20 times larger than Monster with $2.5 billion in revenues. To assuage Monster’s concerns, with its equity investment, Coca-Cola made a credible commitment —a